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The Detroit Bankruptcy

By now, almost everyone knows about the Chapter 9 bankruptcy filing by the city of Detroit. There are some lessons from this sad story that are instructive and should be remembered during the next city or state bankruptcies which almost surely will occur.

The first lesson is the moral hazard that arises when the federal and state governments subsidize poorly managed cities. Moral hazard is the idea that insurance causes the insurance recipient to engage in more risky or reckless behavior. How did Detroit’s bankruptcy occur? In part, the answer is the state and federal subsidies that allowed the City Council and the Mayor to avoid dealing with the reality of Detroit’s deteriorating condition.

The city is now a dysfunctional mess (Detroit_Dysfunction is an article detailing what it is like to work in the Detroit trenches). It is easy to find media reports on conditions in the city but consider just this statistic. On average, if a person dials 911, there will be a police response in 58 minutes. It is not unfair to say that the city is essentially unlivable now that, to a large extent, the middle class has sensibly fled the city for safer environs. The city now has probably the smallest tax base of any major city in the country and it is hard to see how a city can exist without a tax base large enough to finance the legitimate activities of government.

The federal government at one time provided funds amounting to a third of the city’s payroll according to media reports. Couple this “insurance” with a City Council that is completely incompetent and unable to act in anything like a responsible way and you can easily see where the subsidies lead. There are now some calling for a city bailout by the federal government but can you imagine what Detroit or states like Illinois (another train wreck in the making) would do with access to the federal purse?

Another lesson from the Detroit bankruptcy is that it provides a lesson about the result of incompetent or corrupt local government. The City Council signed off on a Consent Agreement with the state prior to the appointment of Emergency Manager (EM) Kevin Orr. That agreement detailed steps to be taken by City Council and Mayor Dave Bing to try to address the city’s many problems. The City Council and Mayor failed to carry out the terms of the agreement and so the EM was appointed by Governor Rick Snyder. The last mayor of Detroit, Kwame Kilpatrick, is now in prison. When the voters consistently elect incompetent and/or corrupt politicians, bankruptcy is the end-game that results.

As I have told students in the classroom, bankruptcy serves a very desirable function in an economy as it provides the opportunity to fix a firm or government or dismantle the bankrupt entity. In the case of Detroit, bankruptcy is a way of solving problems that a corrupt or inept government could not or would not solve.

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  1. August 3, 2013 at 11:19 AM

    Carl:

    Well developed piece. I will share it with my Urban Econ students this fall. Do you have a link to the cited agreement that details the steps to have been taken by City Council and Mayor Dave Bing to try to address the city’s many problems–the one that The City Council and Mayor failed to carry out. For some reason, I am having trouble accessing the hyper-links in your piece. Thanks. –John

    • August 3, 2013 at 9:48 PM

      I went looking for the article and have yet to find it. Kevin Orr was being interviewed in the article I read and said that nothing in the Consent Agreement was done. I will keep looking. RJR

    • August 3, 2013 at 10:34 PM

      Go to George Will’s blog and read his latest post. RJR

  2. August 6, 2013 at 11:44 AM

    As a follow-up to my previous comment, many of Detroit’s woes get laid upon the altar of “White Flight.” However, much of the white flight was engineered after the initial pent-up demand for new post-WWII housing subsided. Less-than-scrupulous builders, construction unions, and realtors pushed to increase the demand for suburban housing.
    In addition, obstinate reliance upon a one-industry oligopoly that enjoyed an unchallenged market from 1945 until the early 1960s promulgated the situation. Management and unions were occupied with fighting one another while the market resurged with global competition. Investors clung diligently to the mass production model and fought industrial diversification, tooth and nail.
    The city’s tax base has all but completely eroded. The city income tax (that further encouraged the flight of the educated and prosperous regardless of color) is left with income taxes largely from minimum wage jobs and a handful of higher-wage earners clustered in select neighborhoods. Furthermore, property values have plummeted. However, the property taxes have not been adjusted to match market value. As a result, residents either hold on to low-value property while paying disproportionately high taxes or they abandon their severely-underwater homes to foreclosure.
    Also, landlords face the continuance of high property taxes along with normally rising utility/maintenance costs. However, a declining number of qualified renters and falling bid-rents create a situation that parallels the rent-control fiasco in the Bronx and other parts of NYC a couple of decades ago. When costs exceeded revenues, landlords walked away and left even more abandoned properties.
    I agree that governments should not be considered or operated in the manner of a for-profit business. For example, when GM had fallen (or unscrupulously was pushed into) some $150B of red ink, it had viable means to return the Federal bail-out loan through reorganization and continued operation (especially with profitable overseas divisions). However, the role of a government like the City of Detroit is to level the playing field for the private sector and provide public goods and services that the private sector lacks economic incentive to provide or simply should not provide (e.g. privately run prisons). Cities must pay for their public products by a reverse transfer (not a one-to-one exchange) of funds, largely from property taxes. However, having seen the massive amounts of properties forfeited to the city and county for back taxes at the City’s Economic Development and Planning offices, I do not see a viable way that the City can pull itself out of a $12B to $22B deepening hole. The forfeited properties are virtually worthless when one considers the basic maintenance costs necessary to secure them. Even if the present financial hole is filled, the ongoing tax revenues are not sufficient to sustain the City at its present size.
    The problem can be traced to two historical incidents. As of 1915, the city barely extended past East/West Grand Blvd. Within little more than a decade, the city limits pushed outward to Telegraph Road. on the west and 8-mile Road on the north. This was due to the intense automotive boom and accompanying housing boom in order to house workers. A second wave of building virtually filled the city with housing after 1945 while the automotive industry attempted to maintain its wartime employment, one that had tripled since pre-war years. The federal government made concessions to the two largest firms that were running afoul of the Sherman Act in the wake of the Alcoa case. As mentioned above, the post-war auto boom was temporary until Europe and the Pacific Rim had rebuilt their capacity and gained market share.
    In short, suburbanization of residences and employment further tipped the already precarious position of the City. However, the fact remains that 80 to 90 percent of the city grew and sustained its size through the support of one industry that has now diminished to less than one third of its size post-WWII size.

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